The Debt Trap

How U.S. borrowing and dollar dominance fuel global financial risk.

The Debt Trap"

How U.S. borrowing and dollar dominance fuel global financial risk.

Pasquale Lucio Scandizzo

In A Scandal in Bohemia, Sherlock Holmes confronts an adversary, Irene Adler, who is particularly difficult to unmask. Adler has hidden a revealing photograph in a room and Holmes has Watson throw a smoke bomb into the room and shout "fire" at the same time. While Holmes is watching, Adler, who was in the next room, rushes to retrieve the incriminating photo and is thus unmasked. This stratagem, very common in the stories of Sherlock Holmes and his imitators, belongs to a more general class, also dear to mystery writers, which we could call the stratagems of the revealing move. Typical of this class is the case in which suspects are gathered in a living room and then an unexpected change of circumstances, for example the light is turned off, induces the culprit to betray himself.

But this type of stratagem is not limited to detective stories. A similar belief, widespread above all in the field of economic policy, but not only in this, is that by creating the right circumstances it is possible to obtain automatic results, which would not necessarily be obtainable by appealing to the intentionality of the subjects involved. The market is the best known of these mechanisms: a liberal conception, even if negative, of its functioning sees it a bit like the parlor where suspicions are gathered and where the unexpected change of circumstances continually forces the culprit or culprits (i.e. the operators who are not successful, the companies that go bankrupt, etc.) to betray their inability and to leave the commune towards unspecified destinations.

Nowhere is this tension clearer—or riskier—than in the domain of sovereign debt. The United States, with its rising deficits and growing foreign indebtedness, is now the economy's best-dressed suspect in the parlor game of finance. Long benefiting from the privilege of borrowing in its own currency while global appetite for dollars supports its role as the world's reserve currency, America is now facing increased skepticism. The growing query asked of it by markets, foreign creditors, and citizens alike is: is this sustainable?

At the core of this question is an inherent asymmetry between creditor and debtor. Sovereign borrowers such as the U.S. are beyond the reach of traditional enforcement. If an economy cannot pay back, it can restructure, inflate, or just roll over debt indefinitely. The threshold is less the amount it pays back, then the answer to the question: is it able to pay back? Once it appears impossible to pay back, the magnitude of the shortfall is of limited concern. It presents a perverse incentive in that the debtor’s interest is less in paying back in full, than in appearing to be able - and willing - to pay back, long enough to gain favorable financing terms.

Strategic behavior is instigated by this incentive. The protracted debtor government constructs a record of resilience and recovery through creating forecasts, reforms, and budget estimates that legitimize its credit status. But creditors may become skeptical of this strategic showmanship and, in return, they may tighten terms, raise interest rates, or withdraw favorable terms. Ironically, this defensive stance increases borrowing's risk and cost—incentivizing the debtor to adopt short-term, risky solutions: gimmicky accounting, unlikely revenue increases, and unsustainable reductions.

But this is not merely an individual-country problem. The individual-country logic of strategic behavior creates mutually destructive effects when taken to the global level. If creditors screen borrowers based on the average market performance in the past, they risk creating perverse sorting: credit-worthy, better than average performing countries, do not borrow because they find the credit terms too onerous and do not wish to be included with riskier peers. On the other hand, less creditworthy nations with poorer records are attracted by the very terms that the creditworthy avoid and plunge in heavily to the market, so that borrowing becomes concentrated among the riskiest actors. This process may create "a market for lemons" in sovereign debt system in which bad risk crowds out good risk to leave debt concentrated among the least creditworthy countries. This is compounded by the fact that most sovereigns can borrow again without penalizing former creditors. New credit is used to finance ambitious projects or political projects in boom times, but when the times turn bad, old creditors take the hit. The risk is quietly off-loaded down the credit chain. The incentives are skewed not only at the national level but throughout the system. Borrowing is motivated less by productive possibility than by the short-run return, while lending is motivated more by fiscal necessity than by solvency in an extended perspective.

Key to this is the fact that this system exists—and in some respects is worsening—due to the lack of an available substitute for the U.S. dollar as an international safe asset. Particular evidence of this is the failure of the European Union to create a credible, liquid, politically cohesive euro-denominated safe asset.

In spite of being one of the globe's biggest economic blocs, the EU does not have an integrated fiscal authority with the ability to launch joint debt instruments in sizes comparable to U.S. Treasuries. Member states raise debt separately, splintering the eurozone's government-bond market and establishing an implied credit hierarchy of countries. In the absence of one unified, respected Eurobond with collective guarantees, investors will continue to use U.S. Treasuries as the preferred global safe haven - not due to American fiscal prudence, but just because there is no strong contender with comparable depth, liquidity, and perceived political support.

This system has two fundamental implications. It channels world demand for safety in one highly levered issuer—the United States—making it able to incur higher levels of debt cheaply than otherwise, and it precludes the development of an open competitive reserve system, reinforcing exactly those asymmetries that create global lending and borrowing distortions.

In substance, the failure of the EU to produce a euro safe asset is directly contributing to the global debt distortion. It compels surplus nations to recycle capital back into US assets, while deficit nations—or those without reserve currency status—struggle over scraps in an opaque system of strategic misrepresentation. Unless there is structural reform on both the national level and systems level, this architecture will continue to channel capital to the most politically influential borrowers—and not the most productive or stable ones.

In this context, the U.S. debt issue is not just an internal problem—it is a systemic risk. The United States is both the world's biggest debtor and issuer of the reserve currency. When it borrows it leads the way. When it indicates that debt can expand infinitely without substantial reforming, it normalizes such behavior elsewhere. But as debt increases, the U.S. will be confronting its own case of the Holmesian crisis: in fact, circumstances may already be shifting – bond yield increase, growth decelerate, and dollar-demand may be disrupted by geopolitics. In other words, fragility is already apparent. Global confidence in U.S. credibility has been undermined by erratic trade policy, unpredictability of tariffs, and currency manipulation rhetoric. As with the 1970s, when America dropped the Bretton Woods dollar-gold peg, there is a growing belief that America's role of global finance leader is increasingly based on inertia rather than principle or discipline.

But the irony is deep. Creditors and debtors alike are stuck in a trap that will be hard to escape. Creditors are afraid of the aftermath of cutting off lending but no longer believe in the durability of what they are lending money to. Debtors are afraid of repayment terms but need to continue to borrow in order to ensure political and economic stability. The creditor is afflicted with the "winner's curse": having won the bidding to lend, it now holds a prize it doesn’t want. The debtor is afraid that the very credit that is keeping it alive could become unsustainable if terms deteriorate.

This interdependence breeds distrust. The larger the U.S. debt gets, the greater the political and market imperative to make it normal—as if trillion-deficit budgets and perpetual borrowing are just aspects of new-age economics. Normal is not sustainable, though. Someday confidence will crumble, circumstances will change, and the moment of reckoning will arrive. In the meantime, America continues to reap the benefits of global confidence in the dollar. But if its trajectory of debt goes unchecked - a function of strategic vagueness, band-aid solutions, and unrealistic expectations—then the parlor of economics will shortly be plunged in darkness. And if that moment of confusion arrives, with no countermeasures having been timely exercised, what is exposed may destabilize the very pillars of world finance.